Category Archives: economics

Why shouldn’t we let the bankrupt go bust?

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A genuine question, and I’m trying to work out the answer (so here I’m thinking out loud).

If Greece defaults – which looks very likely very soon – then there are banks which have made loans to the Greek government which will then not have those loans repaid. This is on such a scale that it is likely that many banks would themselves become insolvent. There is thus great pressure on governments to ensure either that Greece does not default (they’ve lost that one) or, if it does, that the banks are ‘ring fenced’ from the consequences of their actions.

This doesn’t seem right to me.

Assuming Greece defaults (or the other PIIGS) why shouldn’t we let the banks go bust in consequence? After all, it is their decision making which such a fault would put to the test. What would be the malign consequences?

Well, for the ‘average person’ probably not very much. In the UK – and I guess elsewhere – there is deposit insurance, which means that most people’s bank accounts are protected. If one bank goes bust then their customer base is an asset which is then sold on by the auditors who are trying to maximise the asset value from the bankruptcy proceedings. So that side of things is covered.

Those who are richer will get a more or less severe financial haircut, in several ways. Firstly, there is a threshold to the deposit insurance, so deposits above that level would be lost. Second, those who have shareholdings in the bank will – largely – see that investment be destroyed. Thirdly, those who have pensions may be at risk of seeing those pensions lose value if those funds are invested in insolvent institutions.

The thing is, those latter malign consequences I do not see as being anybody else’s business. That is the nature of the free market. If you invest in a company that makes bad decisions then you will likely lose your money. What I most object to is a systemic bias towards privatising gains whilst socialising losses. Or, to put that more simply, I believe that it is shockingly immoral for general taxation to be used to subsidise incompetence and greed. To use an admirable politician’s latest catchphrase, this is simply crony capitalism, and it is corrupt.

At this point the spectre of ‘systemic risk’ is raised. If we don’t stop the banks going bust then civilisation will collapse – I paraphrase, but that is normally the gist. Civilisation is collapsing anyway – and not least because we have ignored the moral foundations of our communities and societies. My view, therefore, is that destroying the notion of moral hazard, making the rich invulnerable to the consequences of their own misjudgements, is part of the problem, not part of the solution.

So I say – let the bankrupt go bust. If we no longer bail out the venal and the incompetent then perhaps there will be a little bit of money left over to look after those in genuine need.

Make sense?

The future is not what it was

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A Courier article – published here 2 weeks after publication in the paper itself.

I write this on the day that Mr Osborne has raised the rate of VAT to 20%. This is necessary, we are to understand, because without that extra income, the budget will not balance and the country will go bankrupt. Sadly, barring a miracle, I don’t see any way in which some form of bankruptcy can be avoided. Now, before I go further, I should say: this is going to be a very depressing article, so don’t read it until you’re in a robustly positive frame of mind (that, or quite convinced, with me, that the Rector’s reckoning can be wrong).

OK.

The future that we face over the next, say, eighteen months to five years, is one of financial depression, specifically deflation. Why do I say this? Well, let us begin by pondering some figures – these are in TRILLIONS of US dollars:

World gross product per year: 55
Total value of global issued currency: 65
Total value of world stock markets: 100
Total value of world real estate: 125
(So far so good, now for the kicker)
Total value of financial derivatives: 1600

Financial derivatives are all those complicated things we’ve heard about on the news over the last few years, like ‘sub-prime mortgages’ and ‘credit default swaps’. The simple conclusion from the above figures is that the financial world has long-since lost touch with the real world of tangible wealth. There simply isn’t enough real wealth corresponding to all the financial obligations that have now been entered into. To put this in simpler, more graphic terms – imagine the amount of wealth in the world as a cake. What the comparatively recent explosion in nominal financial wealth has done is to give a great many different people legal claims to the same bit of cake. On paper, the financial world says that we have a great many cakes – unfortunately there is only the one.

What this means is that the financial system is irretrievably bankrupt. Over the next few years we are going to see something called ‘deleveraging’ – in essence, all the debts are going to be called in. In Warren Buffett’s famous image, ‘we’re going to watch the tide go out and find out who has been swimming without their trunks on’. We are in what I think of as a ‘Wile E Coyote moment’ – remember the great Looney Tunes character, who sprints after the road runner over the edge of the cliff, and manages to keep running on thin air until the moment that he looks down?

Our political leadership has been committed to keeping the show on the road for as long as possible – or at least for long enough to ensure that the movers and shakers are able to get some measure of safety for themselves, eg with the bonuses still being given to Goldman Sachs and other bankers – but they are rapidly running out of options. What we are going to end up living through is a severe contraction of the money supply, what the economists call deflation. Most people are familiar with inflation – the price of everthing goes up – but we’re less familiar with deflation. It sounds at first like a good thing – the price of everything goes down – but the problem is that in a deflation our ability to pay goes down faster. It won’t matter if the average shopping bill comes down to £50 a week rather than £80 if the impact of unemployment and bankruptcies now means that families can only afford to pay £30 rather than £75.

We have been here before – in the 1930s most spectacularly – and the consequences are frightening. One way to get a handle on what it means is to consider real interest rates. If a bank charges a 5% interest rate, and inflation is running at 2%, then the real interest rate is 3% (bank charge minus inflation). However, in a time of deflation, the cost of money could become very high (with consequent damage to the economy) even when the nominal rate of interest is low, or zero (eg bank rate of 1%, deflation of -3% gives a real rate of 4% – the two negatives become a positive). Governments who try to stimulate activity in this context are ‘pushing on a string’, with just as much effect (look at Japan’s recent history). In this context, the very worst place to be is in debt, because the real value of the debt will increase rapidly. That applies especially to mortgages, as the nominal price of housing is likely to plummet leaving a great many people with massive negative equity.

Thomas Hardy once wrote, ‘If a path to the better there be, it begins with a full look at the worst’ (but see here). I’ve only skimmed over the nature of our financial crisis in this article – those who want to explore the background for this post might like to visit a blog site called ‘The Automatic Earth‘ which is where I got the figures from. There is a very great deal that people can do to prepare for these and the other crises that are accumulating around us, linked to the Transition process – but I’ll have to give the positive side in another article.

TBTM20100626

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I think this is worth quoting in full:

To summarize, and to make the sequence clearer using nothing more than explicit assumptions and accounting identities, let me suggest schematically the list of factors that require either much greater flexibility on the part of surplus nations or much greater deficits on the part of the US:

1. I assume that for the foreseeable future the major trade deficit countries in Europe are going to find it very difficult to attract net new financing. At best they will be able, through official help, to refinance part of their existing liabilities.
2. If these countries cannot attract net new capital inflows, their currency account deficits, currently equal to two-thirds that of the US, must automatically contract.
3. If European trade deficits contact, there must be one or both of two automatic consequences. Either the trade surpluses of Germany and other European surplus countries – larger than that of China and just a little larger in sum than the European deficits – must contract by the same amount, or Europe’s overall surplus must expand by the same amount.
4. We will probably get a combination of the two, but a much weaker euro – combined with credit contraction, rising unemployment, and German reluctance to reverse policies that constrain domestic consumption – will mean that a very large share of the adjustment will be forced abroad via an expanding European current account surplus.
5. If Europe’s current account surplus grows, there must be one or both of two automatic consequences. Either the current account surplus of surplus countries like China and Japan must contract by the same amount, or the current account deficits of deficit countries like the US must grow by that amount, or some combination of the two.
6. If the Chinas and Japans of the world lower interest rates, slow credit contraction, and otherwise try to maintain their exports – let alone try to grow them – most of the adjustment burden will be shifted onto countries that do not intervene in trade directly. The most obvious are current account deficit countries like the US.
7. The only way for this not to happen is for the deficit countries to intervene in trade themselves. Since the US cannot use interest rate and wage policies, or currency intervention, to interfere in trade, it must use tariffs.

Tariffs in the US, Asia and probably in Latin America and Europe will rise. These are big numbers and the risk is that the adjustments are likely to occur rapidly. This means the rest of the world will also have to adjust just as rapidly.

I don’t really see how the numbers are going to work…